Why Short Term Market Prices Are Not Good Indicators Of Underlying Value

{ Euclidean Q4 2011 Letter }

We are pleased to write this fourth annual letter to Euclidean’s limited partners.

In this letter, we provide an overview of 2011’s performance. We then share some observations to provide context for these results and to help you establish a deeper understanding of how we think, operate, and look at the future.

Performance

During the 12-month period ending December 31st 2011, Euclidean returned -18.2% after fees to its investors. During this same period the S&P 500’s Total Return (that is, the index return including dividends reinvested) was +2.1%.

During the year, we exited 18 positions. The cumulative total return on these 18 positions is +13.3%. We ended the year with realized net long-term gains of $2.2M.

Since inception, our partnership has returned +42.3% while the S&P 500’s Total Return has been +5.1%. These aggregate gains translate to annualized compounded returns of 10.9% and 1.5%, respectively.

The realized gains, when considered in context of the partnership’s 2011 decline in market value, reflects that we are holding shares in a number of companies where our assessment of their fundamentals remains strong even as those companies’ prices have fallen during the year.

Observations

Back To Our Apartment Building

We engaged in many conversations regarding our Q3 2011 letter and its discussion of the fictional apartment building. To refresh your memory, we used the apartment building story to communicate why we believe short-term market prices are not always good indicators of the underlying value of what one owns. Here’s a summary of the scenario we posed:

The apartment building consistently yields $1,000,000 for your family on an annual basis. After signs of an impending economic downturn, your neighbor offers to sell his identical building for $4,500,000 and thereby establishes a ‘market price’ for your building. We posed the question of whether you should consider selling your building for $5,000,000 as a premium to this new market price.

We suggested that, in a situation such as this, it might be helpful to think about what you would do with the proceeds if you sold. You would have many investment options, each with risks that might prove more real than the risks associated with owning the apartment building. Your ‘risk-free’ choice would involve buying very short-term US Treasury debt. Treasury Bills, which mature in 1-year, currently yield 0.1%. So, ignoring any taxes on the sale, if your family sold the apartment building for $5,000,000 and used the proceeds to purchase T-Bills, you would generate $5,000 a year. This is obviously much less than the $1,000,000 your family had been earning from the building.

Such a disparity might reflect a general sense that the fundamental economics – occupancy and rent levels – of your apartment building were likely to degrade. When economic times are challenging, this kind of fear is not uncommon and perhaps, over the short-term, not misplaced. Still, if you were not desperate for cash and were investing for the long-term, we stated our belief that it would only make sense to trade your current $1,000,000 earning stream for a $5,000 earning trickle if you believed your building would never return to the levels of performance it consistently delivered for many years. After all, it takes a lot of years making $5,000 to equal one $1,000,000 year.

In our conversations around this letter, we were encouraged that the above points made good sense to almost everyone. It was easy to see that the intrinsic value of the apartment building was likely materially higher than its market value. Even in today’s environment, with significant fiscal challenges at home and abroad, our investors and friends were insistent that they would not sell their building at a 20% earnings yield (calculated simply as $1,000,000 in annual earnings divided by $5,000,000 market value) and many asserted they would instead focus on buying their neighbor’s building at that market price.

Given this near universal (and we believe, sound) response, it is interesting how differently many people and professional investors behave when presented with publicly traded companies and their daily fluctuations in market price. If our apartment building was not a family owned business but rather publicly traded on an exchange under the symbol APAR, our experience suggests many investors would lose sight of APAR’s consistent $1,000,000 annual cash flows and focus elsewhere.

Some would focus on APAR’s volatile daily price movements to see if the price was ‘breaking-out’ or ‘hitting resistance’ as a means of predicting what tomorrow’s share price might be. Others would be glued to the daily evolution of heart-stopping political and economic forecasts. The result would be that many of these distracted market participants, as they nervously focus on the short-term and ignore APAR’s underlying value, might willingly sell you quite of few APAR shares at the same 20% earnings yield that seemed so obviously low when APAR wasn’t thought of as an abstract symbol but rather as your family’s very tangible, privately owned apartment building.

We use this example to explain why it is possible today to establish a diverse portfolio of companies that has an aggregate earnings yield of 20% – the same yield associated with our fictional building – in addition to other attractive characteristics.

On the following page, please review the look-through financials of Euclidean’s portfolio as of year-end. [1]

These numbers beg two questions:

How is it that fundamentally strong companies (high Return on Capital, Equity/Assets, and Growth) could be available for purchase at such low prices?

With what appears to be a ‘fundamentally’ stronger portfolio than one would have if he owned the SP500 index, why have Euclidean’s returns lagged this year? And, what should our expectations be for future performance?

How Investors Evaluate Opportunities

How is it that fundamentally strong companies could be available for purchase at such low prices?

In our apartment building analogy, this state of affairs – buildings priced at a 20% yield, in the context of 0.1% short-term interest rates – did not seem rational. So, how is it that there can be such a disconnect between how people view the value of a private, family owned business and how market participants evaluate businesses that trade daily on the major exchanges?

There is a widespread assumption that public markets are more ‘efficient’ than private markets. When someone makes this assumption, he believes that there are better opportunities to find really good deals buying private companies than public ones. The reasoning is that the greater transparency and liquidity of public markets leads to companies being priced more closely to their inherent worth. Thus, there should be fewer opportunities for bargain purchases in public markets than available via private transactions.

Our experiences make us question this notion. Our tenure as business owners and our observations of others, suggest a private business owner is generally not likely to sell his company at a bargain price. The business may be the owner’s largest asset, he likely knows the business better than anyone else, and he is in touch with the cash flows that define its true value. This is why you generally see companies go public or issue additional shares when they can sell at high valuations. Private business owners understand and live our apartment building analogy in a high-resolution way.

Contrast this with investors who focus on publically traded stocks and who are constantly confronted with new market prices and new information.

These individuals often own shares in quite a few companies and make an effort to keep track of how each one is evolving. This is not easy to do. The question, “Do I believe that ACME Corporation is attractively priced,” is a challenging one to answer and the challenge is compounded across a portfolio with multiple holdings. As a result, we believe many investors unknowingly substitute that hard question with questions that are easier to answer.

These easier-to-answer questions are susceptible to having highly volatile answers. Answers to these questions are not rooted to companies’ underlying financial results. Rather, they can be influenced in unproductive ways by the same price fluidity and information flow that supposedly make public markets more efficient. One press release or analyst report can make investors change how they feel about a company. A single CNBC exclusive interview or central bank announcement can cause them to feel more excited or fearful about the world than they were the day before. Moreover, a steep drop in a company’s share price – which, all else being equal, makes its shares more attractive as an investment – often causes investors to feel worse about that company and more fearful about the world in general.

These dynamics provide a basis for understanding why market prices can go to extremes and become disconnected from business’ underlying values. They help explain why investors often feel better about owning businesses at valuations translating to 10% earnings yields than they do when they have much less valuation risk and greater upside potential from owning businesses that are half as expensive (e.g., with 20% earnings yields). Owning the better portfolio is less comfortable and constructing the best portfolios is only possible when the world is most scared.

Performance Perspectives

With what appears to be a ‘fundamentally’ stronger portfolio than one would have if he purchased the SP500 index, why have Euclidean’s results lagged this year? And, what should our expectations be for future performance?

In 2011, we purchased shares in certain companies whose fundamentals subsequently deteriorated and which we sold at a loss. You should view these as mistakes of our approach. We also purchased shares in other companies where our models’ assessment remains strong and which we continue to hold even as their prices have declined. Both these ‘mistakes’ and the ‘jury-is-still-out’ investments were made using the same investment process Euclidean has employed since inception and which has delivered 11% annualized, net returns in the context of a nearly flat market since August 2008.

So then the question perhaps becomes, how does one reconcile that Euclidean’s approach has done well over time but performed poorly in 2011?

From our ‘search’ of the historical record of domestic public equities, we saw the opportunity to deliver strong long-term returns by adhering to the common sense principles we have discussed at length in prior letters. We also saw that to do consistently well over 5 year periods adhering to these principles, we would have to endure frequent shorter-term periods where our results would lag. We are comfortable enduring these periods for two reasons.

First, the fortunes of businesses play out over many years even as the markets are open every day. As an example, consider what happens when a company hits a bump in the road. Perhaps it accumulates too much inventory, confronts a natural disaster, or has a product launch delay. In those instances, a company can post poor earnings for multiple quarters. As investors often extrapolate near-term results far into the future, these temporary issues can cause severe declines in a company’s shares. Often, Euclidean purchases companies caught up in these types of scenarios and we frequently find ourselves purchasing shares well before their prices hit bottom. Even though this can lead to negative short-term numbers, we believe that buying shares in historically good companies at times of pessimism, and buying more when their share prices decline further, is a key to long-term investment success.

Second, that we would have periods of underperformance aligned with our sense, described on the prior page in detail, that investors sometimes focus on things other than companies’ fundamentals. During 2011, this has certainly occurred. Investors have turned away from companies’ financial performance and instead focused on the US and European governments’ inability to make decisions. Many feel that this obsession with macroeconomic and political developments is unprecedented, that perhaps this time it really is different, and that maybe companies’ underlying financial results will be - at best - a secondary driver of their market prices for years to come. We doubt this is the case. Rather, we believe we continue to operate in context of the timeless ebbs and flows in investor behavior that Benjamin Graham so clearly described and which have endured across world wars, the threat of nuclear annihilation, double digit inflation, and numerous sovereign debt defaults.

The world Graham described involves the market behaving like a voting machine in the short-run but over the long-run, the market serving as a weighing machine. Graham’s point was that fear, greed, and other emotions (the voting machine) can drive short-term market fluctuations that cause disconnects between the price and true value of a company’s shares. Over long periods of time, however, the weighing machine kicks in as a company’s economic performance ultimately causes the value and market price of its shares to converge. This oscillation between the voting and weighing machine is like the tides of the sea – it is a fact of life that precedes us and, importantly, will endure long after our investing lifetimes.

As the voting machine held sway in 2011, many attractively priced opportunities became even better values during the year. In this environment, many of our current holdings – even as their financial performance remained consistent and strong – declined in price and this contributed to Euclidean Fund I’s decline in market value. It has also contributed to an increase in the earnings yield of Euclidean’s portfolio, which has risen from 15% to 23% during the year. This has occurred while the SP500’s earnings yield has climbed from 7% to 8%.

Due to both the absolute attractiveness of and the relative widening in the spread between Euclidean’s and the SP500’s earnings yields, we are optimistic about our prospects for future returns.

Summary

A year ago, after 2010’s strong results, we wrote the following:

“So, how should you feel about this year (2010)? Should you be excited about the 20%+ return? If you are excited about Euclidean’s year-end results, should you then also have been nervous during our significant mid-year drawdown?

Please know that we believe performance matters. We just think you should spend very little time seeking to gain insight from a single year’s results. We suggest that you should neither be excited by where we ended the year nor nervous by where we stood in August. Instead, we feel that just as our only rational expectation can be that individual companies will be priced fairly in relation to their financial performance over time, we should likewise only expect our systematic approach to equity investing to deliver attractive results over the long-term.

Our results cannot be viewed out of context of Graham’s voting and weighing machines. Thus, until we have a few 5-year periods under our belts and we have operated across a more diverse set of market environments, we encourage you to focus primarily on the logic of our systematic approach to long-term equity investing.”

*****

We feel these same words continue to provide the best guidance on how you should evaluate Euclidean’s future prospects.

[1] The S&P 500 measures are calculated in a similar way to the Euclidean aggregate numbers. The market values, revenue, debt, assets, earnings, etc. for each company in the S&P 500 are added together. Those aggregate numbers are then used to calculate the metrics above. For example, the earnings yield of the S&P 500 is calculated as the total average 4-year earnings before interest and taxes across all 500 companies divided by those companies’ collective enterprise values (all 500 companies’ market values + cash – debt).

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